This is an article I wrote about my ecommerce experience since the price of gas started to rise. That is when my business, bathroom fixtures, started to tank.
Business Planning In The Face Of Rising Oil Prices
By Steven Pollack
May 19, 2006, 09:30
THE HIGH PRICE OF OIL
As a retailer you have no doubt recently heard the vast whooshing sound of your customer’s disposable income being sucked up by oil companies. At $3 per gallon, instead of filling up their auto for $25 per week they now shell out $50 per car. That’s an extra $25 per week per car not being spent on other purchases.
Think about that, in a very short period, all of our customers’ annual disposable income has dropped by $1,300 to $2,600. That is, of course, assuming prices stay high and wages do not rise.
So the question to be answered is which types of purchases will take the hit? Will it be things like a daily Starbucks coffee or will larger purchases like a car be put off longer? And if this question is answerable, does it create a need for retailers to change their business plans?
THE RELATIVE DEMAND FOR YOUR PRODUCT?
This question brings back the truism that we do not only compete with others in our industry but with retailers in other industries as well for a finite amount of disposable income. The answer comes down to the elasticity of demand for particular products. Usually elasticity of demand refers to the amount of decline in demand given an increase in its price.
In this case, instead of rising prices we are evaluating the drop in a particular product’s demand given a drop in purchasing power. A drop in purchasing power is functionally equivalent to a rise in prices so the same analysis is valid.
Penicillin has a very inelastic demand because no matter what the rise in price the customers keep purchasing the same quantity. Steak has an elastic demand because people will substitute things like chicken or hot dogs if the price of steak begins to rise. So one factor influencing the elasticity of demand is the ability to substitute.
This might bode poorly for things like Starbucks, and restaurants in general, where consumers could substitute home consumption for the more expensive professional preparation. On the other hand, it is well known that certain self-spoils like movies and high end clothing can hold their own in recessions because of the basic human need to feel better in times of turmoil.
The retailer needs to evaluate if his product line will be a victim or a beneficiary of consumer’s emotional needs and substitution choices in times of declining disposable income.
CHANGES IN SAVINGS VERSUS CONSUMPTION
So the relative need for a particular product and the ability to substitute for cheaper products are two considerations. Another is the consumer’s willingness to delay gratification through savings rather than immediately consuming disposable income. As disposable income shrinks because of higher gas prices, certain hard decisions are confronted quicker than usual. Is the consumer more or less likely to delay current needs for long term purchases funded through savings?
If the answer is that he is less likely to save then things like home improvements, replacement of a dishwasher, and saving for their children’s college will suffer. If these savings are very important in the consumer’s mind, however, then the first hit caused by decreased spending power will be to casual purchases like toys and nights out at a restaurant.
Of course it is likely that both current consumption and future savings will take a hit but that does not mean they will be reduced in equal proportion. The retailer needs to look at his product line and decide if it represents the type of good or service that will be slightly or greatly affected by the sharpening of the consumer’s consumption versus savings choice brought on by declining spending power.
IN BOOM TIMES WE THRIVE BUT IN RECESSIONS WE SURVIVE
One response to higher oil prices, and declining disposable income, is for employees to demand higher wages and business to raise prices. The Federal Reserve, however, will cut that response off at the knees with higher interest rates. Higher interest rates slow down the economy by choking off borrowing. Consumers borrow less, and therefore spend less, which deprives business the opportunity to raise prices. (The dilemma for the Fed is that this also causes business to borrow less, thereby reducing growth and producing stagnation)
That does not mean that an individual business cannot raise prices if its particular demand remains inelastic, just that the Fed will make it difficult for everyone in the aggregate to do so because excess cash will be sopped up to avoid a negative cycle of declining spending power leading to rising prices and again leading to declining spending power.
The better strategy for retailers who are not lucky enough to sell an inelastic product is to consider doing the opposite of what was done in an expanding environment. When times were good a business typically expands the product line to gather more sales at the fringes of demand. Now it is time to consider culling the inventory back to the basic items that sell consistently well.
Unsold inventory goes bad with the seasons so even though you may be tempted to weather the storm with the bigger selection you achieved during the boom times, your cash flow is dependant on inventory turn. If only a portion of your inventory turns well, then the other inventory is tying up your capital.
By cutting back to the basics, you might find that instead of being a superstore or category killer, you will return back to operating as a niche retailer. If only your core items are moving then advertising to the broader market in order to get the fringe sales is wasteful to the degree that the fringe sales are the ones declining due to decreased spending power. The benefit is that your marketing campaign can become more focused and efficient.
Likewise, cutting back the inventory will allow for a reduction in other overhead costs. Maybe you can cut back on your space and employees to the point where you utilize these costs more efficiently and profitably. Efficient use of assets always goes hand in hand with profitability. During boom times there are opportunities to expand the operation while maintaining efficiency and therefore profitability.
When markets are declining though it is less intuitive to retreat back to a smaller position because retailers become comfortable with the status quo. The market, however, will force these changes on you so it is better to proactively retreat to a position of high efficiency and sustainable profitability than to wait until the drag of slower sales affects your profitability through the inefficient use of a bloated infrastructure.
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